Power of Compounding – An Illustration

We all have heard multiple quotes and quips on the power of compounding by great investors. Hence, I will not give any gyaan on the compounding theme.

What I do want to illustrate is a quick and dirty table to evaluate investments. But that comes later. Trouble-sharing first 🙂

I have had some trouble in evaluating investments. The trouble is/was two-fold:

a) Quality companies vs Cigar butt companies: Assuming a fixed level of cash that you have, there are some cigar butts in the market which can give you a quick 20-40% return if things turn out well versus a few quality companies which can compound at 15% year on year. The deal though is you need to get out once the cigar butt is fairly valued versus continuing to stay invested in quality companies. Let’s say in an optimistic scenario we do get out of this cigar butt investment successfully, we have the problem of re-investment. The problem of re-investment is not simple since you may no longer have any undervalued stocks to invest in. You’ll probably earn 10% on a RD (or a ultra short term debt fund) and that’s about it. Compare this scenario with investing in a quality company (say a Page/GSK etc) where you don’t have to worry about getting out at the right moment/constantly monitor stuff/significant re-investment problem. These are steady compounders, which if some basic stuff goes well will compound atleast 15-20% for the next few years.

b) Falling markets: I have had this peculiar fascination with opportunity cost (which sometimes has stumped me into stupor). In a falling market, I want to invest in say Stock A which can give me say 20% returns for the next 5 years from that invested price. If the market falls some more, I might have another stock, say Stock B which can give me 30% returns for the next 3 years  from that invested price. Assuming I already invested in Stock A, should I get out and invest in Stock B? Or should I stay invested in Stock A? If the stock market falls further, will I have a Stock C that can give me higher returns and ad infinitum. I need to invest based on which company can generate higher returns for a longer period of time. (In general, to avoid the stupor I have learnt to just invest if I can get a 20% CAGR for 5 years).

Net-net, the question I am trying to answer based on the two-fold trouble is – how many times will my money multiply by, in say x years?

I have come up with a matrix for a quick and dirty check of how many times will my money multiply by, given a CAGR and number of years (instead of calculating every single time). Here it is –

image

Taking the example above, a 20% CAGR for 5 years (refer grey shaded areas) – my money multiplies by 2.5 times. 30% CAGR for 3 years – my money multiplies by only 2.2 times. Hence, the prudent way is to invest in 20% for 5 years.

Also the reason why investing in quality companies for a longer timeframe helps better even though the CAGR for a year or two might be less than investing in a cigar butt for a similar time frame.

As I said earlier, no genius in the matrix. We can calculate it using the compound interest formula every single time. I am lazy though, and hence this matrix helps me for a quick check 🙂

P.S: If you find a stock with 60% CAGR for 10 years, please drop me a mail. We both can retire comfortably 🙂

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  1. #1 by rapidriser on April 10, 2012 - 7:02 PM

    Infosys gave 70% CAGR for 10 years. If you find a time machine we can retire today. :-)))

    • #2 by ashwinidamani on April 10, 2012 - 7:06 PM

      How I wish ~~!!

  2. #3 by ashwinidamani on April 10, 2012 - 7:05 PM

    Another similarly simple tool is the “Rule of 70” – This rule says that if your money compounds at a given percentage, the time taken to double the principal would be 70 divided by compound interest (growth rate). So money growing at 20% CAGR will double in approx 3.5 years…!!!

    Ashwini Damani
    http://goldensilt.blogspot.com

  3. #4 by kdaaku on April 10, 2012 - 8:25 PM

    @rapidriser – You have substituted an investment problem with a science (‘time machine’) problem 🙂
    @ashwini – It’s actually ‘rule of 72’.

  4. #5 by Dhwanil Desai on April 12, 2012 - 4:21 PM

    I think you have discussed a very interesting dilema faced by many value investors. After reading your article, first thing that struck me is, you are talking about how to allocate capital, considering number of options one has. I have struggled with this issue for a while and finally found some answer (probably vague and slightly subjective) to my dilema in Mr. Donald’s capital allocation framework

    http://www.valuepickr.com/forum/valuepickr-scorecard-aug-2011/399834292

    Subsequent to that, I have tried to illustrate the same framework in my posts at
    http://www.valueinvestinginpractice.blogspot.in/2012/03/applying-capital-allocation-framework.html#more and

    http://www.valueinvestinginpractice.blogspot.in/2012/03/applying-capital-allocation-framework_10.html.

    I personally think that instead of assuming a specific number for compounded return on investment to make a decision to buy a stock, it is better to consider other factors such as management quality, scalability of business and valuations to come up with holistic matrix which will relatively objectively capture the attractiveness of an investment from various angles.

    Would love to know your views on the same.

    Best Regards
    Dhwanil Desai

  5. #6 by kamalsinh on April 23, 2012 - 3:15 AM

    Reblogged this on WordPresskml.

  6. #7 by mohan on April 25, 2012 - 1:17 AM

    hi Kiran,

    Iam looking for a website (free or paid) where i can set 52 week low alerts for the stocks present in my portfolio. I searched a lot in the google but many sites are giving our custom price triggers but that is not iam looking for. If a stock in my portfolio goes 52 week low, it should alert me via email.

    Please reply if you know any website.

    Thanks,
    Mohan.

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